Sunday, November 2, 2008

How to regulate unregulation

Last updated: November 4, 2008

November 2, 2008

I would say that it's now getting really hard to fail to notice how much the policies adopted by the fed in the wake of the crisis are similar to those that have created the bubble in the first place. The interest rate is down to 1% and concerns for deficits and debt ratio have been all thrown over the board as the US is trying to reflate its way out of a deepening recession.

A few days ago the current fed chairman has had the following to say about the situation of the housing market:

Speaking about the credit crisis that started in August 2007, Bernanke said it began with the end of a prolonged housing boom in the U.S. that exposed "serious deficiencies in the underwriting and credit rating" for mortgages, particularly subprime mortgages, loans made to borrowers with weak credit histories.

Banks and thrifts are still making new mortgage loans during the current credit squeeze but have tightened terms considerably, "essentially closing the private market to borrowers with weaker credit histories," Bernanke said.

. . .

He did say that private companies have basically stopped all of their activities to purchase mortgages and collect them into large pools to be sold as securities, something now only being done by Fannie, Freddie and Ginnie Mae. By contrast, private companies accounted for half of the market for mortgage-backed securities in 2005 at the height of the housing boom.

"That experience suggests that, at least under the most stressed conditions, some form of government backstop may be necessary to ensure continued securitization of mortgages," Bernanke said.

What it basically means is that the US economy is back to the square one as the financial system is largely back to its previous shape that prevailed until the regulators moved in to unleash the lending binge. The private sector has all but abandoned the MBS market leaving Fannies and Freddies to fight their lonely battle for expanding home ownership. The banks have also recovered their past prudence and right now the regulators have no chance to force them back into reckless subprime lending even if they legislate another ten CRA acts.

In view of the above, questions arise regarding the policies adopted by the fed. For starters, there may be no liquidity crisis as such or it may have reasons different enough to justify calling the actions taken by the fed misdirected. As always the regulators are now way too late to the party. The problem has already transformed itself from one of lack of regulation or self regulation so famously decried by Greenspan in front of the Senate committees into one of a massive over-self-regulation by the private sector. While the politicians-regulators are promising to introduce the world to a new era of enlightened state regulation, there's very little left now that can or should be regulated. In fact, it now comes all down to just the very opposite of it, namely, how to unregulate the beast out of a corner into which it threw itself after the housing market had collapsed taking on its way down banks and funds all across the country.

So we are now having the following situation. All talks about the end of capitalism and return of regulation notwithstanding, hardly any of the incoming regulation will have any practical effect on or relevance to the situation. Regulating some of the more exotic among derivative markets is not necessarily a bad idea, but for a few next years any person brave enough to call CDS and CDO by their names, will be at risk to be shot up right in front of the executive board. On the other hand, all the pumping of the financial system currently under way may fail to unlock the credit gates and unless the fed is ready to nationalize the entire banking industry to force open credit lines, it should better come to terms with the situation. The dollar's status of the world's reserve currency is not guaranteed to the US for eternity. Unless the fed wants to see its country finally going bankrupt or washed away by the tsunami of returning dollars, it should better temper its enthusiasm for its current methods.

November 4, 2008

AIG and its swaps

The story making rounds in the last days in the US media is about AIG having essentially run through all 100 something billion dollars provided to the company by the fed in emergency lending. Both the Washington Post and New York Times were running stories on this as well as some others. The details are not clear but it appears that the bulk of the rescue package was wasted by the group on posting more collateral on its troubled credit default swaps. Derivative contracts are at the heart of the group's meltdown.

When AIG went down, the Economist said that one of the great mysteries had been resolved, namely who was taking on the risk banks and investors were shedding so massively in the recent years. At the peak of the boom the spread between the t-bonds and private bonds has shrunk to a mere shadow of its former 3%, as the bulk of private bonds had been underwritten by somebody. AIG collapse has prompted some like the Economist to say that they saw the light and know the answer.

However that was a double sided mystery. Its other side was the existence of an absolutely huge CDS market exceeding the size of the whole US economy. This means that however well everything around was underwritten in the recent years, the actual amount of CDS contracts by AIG and its likes should be even bigger. Another thing is that the enthusiasm of AIG, Lehman Brothers and others for CDS contracts should have been equally matched by the enthusiasm of their counterparties to these contracts. Who are they and where most of this stuff is hiding now should be another mystery of our time. On several occasions defaults were accompanied by claims that surpassed the value of actual assets by orders of magnitude. This points to the possibility that a significant portion of these contracts are a pure speculation by those who were smart enough to anticipate the incoming crash. Unfortunately neither article has any information to share on who are the counterparties to the AIG CDS.

Back to the rescue package, one question that sure troubles many now is how much of the financial system can be salvaged and if beyond the escalating debts and deficits, the massive rescue packages unleashed by the fed and Treasury are actually achieving something. The Economist claimed that a catastrophe has been averted, but many are begging to disagree saying it was only delayed. It may well be the case that the props provided by the fed and treasury to financial institutions have only served to suspend the system in an uncertain situation of neither full bankruptcy nor really functional state the AIG style. The regulators may hate to consider more radical approaches such as collapsing the bulk of the financial system in a controlled manner, or taking some drastic action on all these credit default swaps and their friends, up to annulling a good part of them altogether by decree, but the currently adopted methods of prolonging this agony indefinitely are risking to spread it over the whole next decade, turning it into one to be wasted in a slow and painful stagnation.